Chapter 5 Principles of Corporate Finance Eighth Edition Why Net Present Value Leads to Better Investment Decisions Than Other Criteria Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 2 McGraw-Hill/Irwin Topics Covered  A Review of The Basics –NPV and its Competitors  The Payback Period –The Book Rate of Return  Internal Rate of Return  Capital Rationing

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 3 McGraw-Hill/Irwin NPV and Cash Transfers  Every possible method for evaluating projects impacts the flow of cash about the company as follows. Cash Investment opportunity (real asset) FirmShareholder Investment opportunities (financial assets) InvestAlternative: pay dividend to shareholders Shareholders invest for themselves

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 4 McGraw-Hill/Irwin CFO Decision Tools Survey Data on CFO Use of Investment Evaluation Techniques SOURCE: Graham and Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 61 (2001), pp

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 5 McGraw-Hill/Irwin Book Rate of Return Book Rate of Return - Average income divided by average book value over project life. Also called accounting rate of return. Managers rarely use this measurement to make decisions. The components reflect tax and accounting figures, not market values or cash flows.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 6 McGraw-Hill/Irwin Payback  The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay.  The payback rule says only accept projects that “payback” in the desired time frame.  This method is flawed, primarily because it ignores later year cash flows and the the present value of future cash flows.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 7 McGraw-Hill/Irwin Payback Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 8 McGraw-Hill/Irwin Payback Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 5- 9 McGraw-Hill/Irwin Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return IRR=28%

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return Pitfall 1 - Lending or Borrowing?  With some cash flows (as noted below) the NPV of the project increases s the discount rate increases.  This is contrary to the normal relationship between NPV and discount rates.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return Pitfall 2 - Multiple Rates of Return  Certain cash flows can generate NPV=0 at two different discount rates.  The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%. Cash Flows (millions of Australian dollars)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return Pitfall 2 - Multiple Rates of Return  Certain cash flows can generate NPV=0 at two different discount rates.  The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%. 600 NPV Discount Rate IRR=11.6% IRR=-44%

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return Pitfall 2 - Multiple Rates of Return  It is possible to have a zero IRR and a positive NPV

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return Pitfall 3 - Mutually Exclusive Projects  IRR sometimes ignores the magnitude of the project.  The following two projects illustrate that problem.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return Pitfall 3 - Mutually Exclusive Projects

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return Pitfall 4 - Term Structure Assumption  We assume that discount rates are stable during the term of the project.  This assumption implies that all funds are reinvested at the IRR.  This is a false assumption.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Internal Rate of Return Calculating the IRR can be a laborious task. Fortunately, financial calculators can perform this function easily. HP-10BEL-733ABAII Plus -350,000CFj-350,000CFiCF 16,000CFj16,000CFfi2nd{CLR Work} 16,000CFj16,000CFi -350,000 ENTER 466,000CFj466,000CFi 16,000 ENTER {IRR/YR}IRR16,000 ENTER 466,000 ENTER IRRCPT All produce IRR=12.96

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Profitability Index  When resources are limited, the profitability index (PI) provides a tool for selecting among various project combinations and alternatives  A set of limited resources and projects can yield various combinations.  The highest weighted average PI can indicate which projects to select.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Profitability Index Cash Flows ($ millions)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Profitability Index Cash Flows ($ millions)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Profitability Index Example We only have $300,000 to invest. Which do we select? ProjNPV InvestmentPI A230,000200, B141,250125, C194,250175, D162,000150,

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Profitability Index Example - continued ProjNPV InvestmentPI A230,000200, B141,250125, C194,250175, D162,000150, Select projects with highest Weighted Avg PI WAPI (BD) = 1.13(125) (150) (25) (300) (300) (300) = 1.01

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Profitability Index Example - continued ProjNPV InvestmentPI A230,000200, B141,250125, C194,250175, D162,000150, Select projects with highest Weighted Avg PI WAPI (BD) = 1.01 WAPI (A) = 0.77 WAPI (BC) = 1.12

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Linear Programming  Maximize Cash flows or NPV  Minimize costs Example Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xd subject to 10Xa + 5Xb + 5Xc + 0Xd <= Xa - 5Xb - 5Xc + 40Xd <= 12

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Vegetron Case Table 5.2

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Vegetron Case Table 5.3

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